HC 742 Electricity Market Reform

CHPA response to ECC Committee Enquiry into the EMR

Summary and Introduction


1. The Coalition Government has recently published its consultation on reform of the electricity market. Whilst Government has a clear overarching objective; affordable secure, low carbon electricity   , there is an absence of a clear narrative of how the Government will seek to achieve this. The consultation sets out four ‘tools’ for reforming the electricity market but does not set out the detailed issues which it is seeking to address through the EMR. The CHPA recommends that the scope of the EMR be clarified with Government identifying the key issues within the market that it wants to see addressed. Once these have been identified, the Government can then determine how the chosen policy measures (tools) can be deployed for delivering the energy system that Government envisages for the future.

2. The key issues of market performance that need to be considered in greater detail are:

Demand side response

· What is the scope for demand reduction, embedded generation and actively managed network infrastructure to take excess power at times of negative power prices, to provide cost-effective system services and limit the requirement for the construction of additional generation and network capacity?

· How does the market currently value these services and what changes (if any) need to be made to ensure that these services can play a role where they are cost effective

3. The CHPA believes that there is a significant potential role for new business models that can respond to emerging system requirements and arbitrage opportunities, and that through encouraging the development of this market the Government could limit some of the cost increases associated with a move to a low carbon economy. Whilst the consultation mentions demand-side measures there is a strong focus on new generation which may lead to the potential for demand response from being underexploited.

New market entrants

· What are the barriers to new market entrants both on generation and supply? What changes to the market are necessary to facilitate new market entry

· What are the key points of contestability in the current market – are these sufficient or should the reform facilitate greater contestability.

· Is low market liquidity limiting new entrants through an inability to determine forward prices?

4. The CHPA believes that the current market structure limits the ability for both new market entrants and smaller, independent parties to compete effectively with the established market participants. Although experience suggests that the greatest impact has been upon new suppliers, the scope for generators existing outside of the highly-insulated, Renewables Obligation-subsidised market has been limited since the NETA and BETTA reforms of the early 2000s. The principal barriers to new market entry in the UK market today arise from:

· A lack of liquidity and transparency in forward wholesale markets;

· Considerable and unpredictable imbalance risk;

· The two factors noted above combine to inhibit the formation of a reliable reference price for both investment and operational dispatch decisions;

· A competitive advantage in addressing these risks for vertically-integrated market participants;

· High regulatory costs and overheads, which afford considerable economies of scale to larger market participants.

The role of the energy consumer

5. The Government’s consultation mentions new support options but makes limited mention of the mechanism by which these would be funded or administered. It is vital that the political acceptability of the move to a low carbon economy is retained and strengthened as increasing prices and new generation assets will inevitably cause some concern. The CHPA believes that there is a need for a clear narrative for consumers about the impact of these actions on their energy bills. More importantly, there should be greater focus upon those mechanisms that will help to insulate customers from the increased costs of new generation investments, most notably through improved energy efficiency and enhanced competition at appropriate, contestable elements of the supply chain. For example, aggregating demand response and small scale- or micro- generation through Energy Services Companies (ESCos) may provide a mechanism for consumers to become more actively engaged with energy issues and help them to benefit financially from the services they can offer. A fundamental commitment to encourage these options within the scope of the EMR may help to limit future public concerns over the costs of the low-carbon transition.

6. An EMR process occurs once every ten to 20 years and it is vital that Government seizes the opportunity to examine the successes and weaknesses of the current market before proposing how it will facilitate a change in the generation mix. The CHPA would encourage the Committee to examine the options for reforming the market fundamentals to help crystallise some of the issues that need to be addressed

Responses to specific questions from the Committee


What should the main objective of the Electricity Market Reform project be?

7. The Government has correctly set out overarching objectives for the future of the electricity market; affordable secure, low carbon electricity. Whilst this is helpful, it is too broad to inform the range of interventions that may be needed to deliver on those objectives. The EMR consultation moves from this suite of high level objectives and lands upon the focused target of facilitating new investment in low carbon generation assets, without considering the wider structural market issues.

8. The CHPA recommends that in taking forward its programme of reform, the Government should adopt a more forensic and comprehensive approach in addressing the barriers or limitations that are evident in today’s electricity market place. This should include consideration of:

· Price transparency and the availability of a recognised ‘reference price’ against which new investments can be appraised

· The openness of the market to new entrants on both the generation and supply sides of the market

· Wholesale electricity market liquidity

· Imbalance risk

· Consumer engagement

· The pricing signals for demand-side measures and embedded generation

· Practical points of contestability in the supply chain

9. Whilst the consultation mentions some of these issues, there is an absence of a clear in-depth analysis of what issues exist and, vitally, how structural market reforms could address these. By placing these issues as the central point of market reform, the Government would be better placed to develop proposals for new interventions, such as a Feed-In Tariff. The need for the scale of the interventions proposed may be due to areas of market failure. Addressing the causes of any points of market failure first will clarify what additional tools may be needed to ensure that the overarching objectives are achieved.

Do capacity mechanisms offer a realistic way of achieving energy security, low-carbon investment and fair prices?

10. A capacity mechanism is simply a tool for ensuring that generation assets or demand reduction are available to provide net changes in power demand during a given time period. A capacity mechanism cannot deliver the overarching aims of the EMR. The CHPA believes that Government needs to identify better any market issues and what may be a barrier to energy security, low-carbon investment and fair prices and use the evidence from that to determine what further tools are needed to ensure that the overarching aims are met.

11. A capacity mechanism that incorporates demand response, embedded generation and transmission connected generation within the suite of options to manage grid imbalance (both excess demand AND excess generation as is likely to happen with increasing renewables penetration) will probably be a necessary tool to manage the anticipated future power generation mix. Well designed, a capacity mechanism can contribute to limiting price increases (through demand management services and embedded generation) and carbon emissions (by dispatching capacity services on an emissions based mechanism). Furthermore, by opening up capacity services to embedded generators and ESCos, it may be possible to access a n existing market of operators who are able to offer capacity services but for whom the current market arrangements do not offer value on this area.

What is the most appropriate kind of capacity mechanism for the UK?

12. Any capacity mechanism needs to be considered within the context of wider reforms to the market and in particular the approach taken to the wider incentivisation of low-carbon generation.

13. Given the deterministic approach to encouraging low-carbon generation proposed by the Government, with contracts struck with individual generators and with baseload or ‘must-run’ generation dominating the new build, consideration should be given to a focus on availability to dispatch power rather than a mechanism simply based on installed capacity. A system base purely on installed capacity may see payments to generators who are unable to offer capacity services, or who are rewarded twice for providing the same service.

14. Furthermore, in the interests of stimulating competition and encouraging the lowest-cost market response, any capacity market should be opened as widely as possible to allow the full scope of demand response options to play a part in the market. A simple mechanism on generation assets may lead to the development of significant numbers of open cycle gas turbine units which would be unlikely to contribute emissions reductions and may not be a cost effective solution. A mechanism that facilitates the use of existing assets, such as CHP units, as well as demand reduction may deliver far better value to consumers for the same impact on gird balancing and frequency.

15. In the future, it is likely that negative electricity prices will be part of the wholesale market. In cases of excess generation, services which absorb excess generation and use it usefully, such as charging electric vehicles and storing energy as heat for use in heat networks, may be required. A capacity mechanism should be designed to provide the flexibility for both excess demand and excess supply.

Should the system of Feed-in Tariffs be focused on particular technologies or maintain a wider technology-based view?

16. The proposed contract for difference feed in tariff (CfD FiT) is an appealing mechanism for delivering low carbon generation and with the right design can facilitate wider market participation, with the corresponding benefit of increasing capital flows. Recognising that there are significant technology, construction and operating risks associated with each of the principal generating technologies which the FiTs regime is targeting it will be vital to ensure that each of these technologies, alongside a wider range of demand-side measures are incentivised under the new arrangements. At the same time it will be necessary to avoid excessive rents, in order to maintain the acceptability of the policy to UK consumers. These considerations would tend to favour an approach where differentiated tariffs are offered to different technologies or measures. The interaction of the new CFD FiT with the current FiT also needs to be considered.

17. A further design consideration will be the determination of the level of capacity contracted under the FiT regime, and the corresponding extent of the capacity market. The more FiT contracts in place, the fewer periods over which participants in the capacity market may be required to operate, so restricting their opportunities to recover costs through generation.

Will it be feasible to deliver EMR in one go, or will regulations and implementation be spread over time?

18. The reform process will take several years. Whilst this may appear a problem, a clear timetable and narrative of what is sought by Government will be able to provide the necessary clarity to prevent a collapse of investment or confidence. Whilst it is important for Government to aim for a quick and efficient resolution of the EMR process, it is vital that appropriate time is taken to develop and examine all proposals. The EMR is a process that occurs every 10-20 years and, as such a long term reform, sufficient time needs to be given to ensure that it will deliver what Government wants. The time spent in designing and implementing a robust and enduring market framework will be rewarded through fewer interventions to correct design flaws once the new arrangements become operational. In this respect, the 2020 timeframes adopted in EU legislation may be acting to compromise prospects for efficient, long-term decarbonisation pathways by encouraging short-term, expedient actions.

19. There has been much focus on the need for certainty for new investors, which is appropriate, but the impact of a rushed reform process could be long term damage to key aspects of a successful market such as liquidity or barriers to new entrants. In the absence of a comprehensive approach the EMR, the CHPA is concerned that the process may become overly-focused on bureaucratic detail, whilst losing sight of the bigger picture.

Will market reform increase political risk for investors or create certainty?

20. It is inevitable that reforming the market will create some degree of uncertainty but it has become clear that the current market arrangements are unlikely to deliver a cost effective decarbonisation of the UK electricity generation mix, in line with UK targets, whilst maintaining security of electricity supplies. As a result, the Government should develop a strategy for minimising uncertainty in the form of setting out a detailed set of metrics to be addressed in the reforms and a reasonable timetable. The lack of clarity for the direction of the EMR and the confused nature of the consultation document has already had a direct impact on the liquidity of the traded market.

Will the Government’s proposed package of carbon price floor, EPS, FITs and capacity mechanism provide sufficient transformation to achieve goals on climate change, security of supply and affordability?

21. No. The consultation does not comprise comprehensive analysis and steps for market reform. As set out earlier, the fundamentals of the market need to be reviewed and examined. Based on the analysis of the function of the market fundamentals, Government needs to determine what reforms need to be implemented to ensure that the market will function both now and in a low carbon generation scenario. Once these have been established that Government may best consider what additional interventions are required to secure low carbon investment and security of supply.

What synergies and conflicts will there be between proposed mechanisms and policies already in place?

22. There is the opportunity to develop synergies between new policies and existing structures but it is not possible to define these (or the potential conflicts) without greater detail.

23. The most significant interface issue is that which lies between the contracted FiT market and the proposed capacity market. The greater the level of volumes potentially contracted for under the FiT regime, so the smaller the volumes traded in the capacity market and the greater the prices that will need to be offered to capacity market participants to make capacity available and respond to system requirements. In an extreme situation, with excessive volumes of ‘must-run’ FiT-rewarded generation, the capacity market will be dominated by flexible generation reducing output and by energy storage. A major challenge for the Government will lie in achieving the optimum balance between incentivising low-carbon generation and low-cost response.

24. The proposed level for an emissions performance standard will have limited, if any, impact on the status quo. The interaction of the CfD FiT and any capacity mechanism will be vital to the effective operation of the market and delivering value for money to consumers but this is not examined by the consultation.

Will a carbon floor price be feasible in the context of EMR and at what level should it be set?

25. The proposed carbon floor price is a feasible mechanism for Government although it has several key issues that need to be considered.

· As a mechanism for providing a minimum carbon price that passes through into the wholesale electricity market, it is appropriate that only fuels used to generate power pay the carbon price levy. This may appear self-evident, but it is the case that the Government’s proposals for Carbon Price Support include proposals to impose the carbon price levy on fuels used to generate heat in combined heat and power plants. This situation creates an unmanageable cost risk for CHP operators which may cause them to cease operating in CHP mode, leading to a direct increase in UK emissions.

· The interaction of the proposed mechanism with the EU Emissions Trading Scheme may create significant issues for future interconnections with the continent as there will be a carbon price disparity. This could lead to an increased drive to import power as it may have a lower cost.

· A carbon support price mechanism will only lead to cost pass through (to the wholesale market) during periods when fossil fired plant is the marginal (price setting) plant. With a predicted increase in power generation from low carbon sources, it is likely that there will be periods when non-fossil plant operates as the marginal plant. The result will be no carbon cost pass-through to the market and the loss of the intended signal from the carbon support price.

What effects will EMR have on the development of capacity for electricity storage and the development of interconnectors between the UK and other electricity markets?

26. The EMR proposals set out by Government set out the value and theoretical options for both interconnectors and storage but there are no detailed proposals on how new capacity in these two areas will be brought forward through the EMR. In addition, the discussion of storage is primarily limited to pumped storage for which there is limited opportunity for expansion.

27. The CHPA believes that storage both pumped storage and other means such as thermal storage will have an increasingly important role to play within the electricity market but there needs to be a clear examination of the role that it can play and what value it can contribute. The fourth chapter of the Government’s consultation sets out a range of options that can be considered for managing the change in generation mix but there is an absence of analysis as to the value that these options present, the saleability of these options and what (if anything) in the market needs to change to ensure that these services are valued sufficiently for them to be provided.

28. The CHPA recommends that the Government commissions an examination of the potential for the fullest range of demand side response measures (including embedded generation, demand reduction, use of excess generation and localised balancing services) and a cost benefit analysis of what these may offer a more diverse and unpredictable energy mix. The CHPA notes that opening up of the Danish district heating market to provide services to accommodate variable power generation has dramatically smoothed power prices and facilitated much needed system balancing. As part of such a review, the potential costs and benefits of moving to a system of actively managed electricity distribution networks (DNs) should be examined. The CHPA believes that there is substantial opportunity to save costs by reducing the level of infrastructure development required for DNs by moving to a system of active management. Such cost savings may be key to limiting the rise in customer energy bills and hence, retaining vital political acceptability for energy decarbonisation.

For more information please contact:

Dr Tim Rotheray

Policy Manager

Combined Heat and Power Association

Tel: 020 7828 4077

Mob: 07540 982 014

E: tim.rotheray@chpa.co.uk

W: www.chpa.co.uk